How Implied Volatility Impacts Returns in Trading

When you decide to trade options, it’s important to understand the impact implied volatility has on option prices and returns. Implied volatility (IV stock) reflects the degree of uncertainty traders have about future stock prices, so it plays an integral role in determining how much risk you face when trading options.

Fortunately, even if you don’t work in finance or trade options on the stock market, understanding how IV impacts your returns can help you make smarter investment decisions in general.

What Is Implied Volatility?

Before we dive into how implied volatility impacts returns, let’s look at what implied volatility is and how it affects options. Simply put, IV is an indicator of an option’s price behavior over time—it’s essentially a measurement of risk that incorporates factors like time value and volatility. Thus, there are two primary types of implied volatility: historical and implied.

IV Indexes

As stock prices fluctuate, implied volatility indexes follow suit. A company’s implied volatility index is its actual volatility (IVA) multiplied by its corresponding option’s theoretical value (TV). According to stock investors at tastytrade, you can calculate IV indexes based on options on individual security or market-wide indexes like S&P 500 Index (SPX), NASDAQ Composite Index (COMPX), DJIA, and others. Stock Market guides like tastytrade are also

Implied Volatility and Options

In options trading, implied volatility measures how volatile a market expects a certain underlying security to be over a specific period of time. It can help calculate options prices by determining an asset’s theoretical value or fair price based on future expected returns or dividends. Options are derivatives, which means they’re bets on something else. And you bet on Implied Volatility because it affects all option prices.

What Is Risk Premium?

The risk premium is a theoretical measure of compensation for an investment’s uncertainty. Financers usually measure it by comparing one investment’s average return with another investment’s risk-free rate (such as an interest rate on a T-bill). The difference between these two rates represents that investment’s inherent or perceived risk. If you can quantify that risk, you can then estimate its reward and set a price on it to determine its value and whether or not we should invest.

Impact on Options Chain Prices

The IV of a stock, along with interest rates and dividends, will determine how institutions price it in an options chain. A relatively high IV (implied volatility) will cause a stock to be more expensive on an options chain than one with a lower IV. This makes sense since you can expect stocks to move more over time, and they should cost more when you buy them; higher IV = higher option prices. Constantly watching for how implied volatility impacts your strategy and portfolio is important for managing your risk.

Investors can put their fears to rest by remembering that implied volatility is not a very good predictor of stock prices. Changes in investor sentiment may be more important than actual price fluctuations when it comes to volatility. Changes in investor sentiment may have an even larger influence on volatility than actual market fluctuations do.